The Money In Your Wallet Is About To Be Collateralized By Your House

Lots of people are understandably concerned about what happens when the Fed starts to shrink its balance sheet.

At some basic level, the angst is tied to the fact that what we’ve seen since the crisis in terms of central bank balance sheet bloat is unprecedented and so, it’s by definition impossible to know what happens when it’s unwound.

One thing we know for sure is that central banks have effectively obviated the need for private security buying by reducing net supply to zero. Once that starts to go in reverse largely due to ECB taper and SOMA rolloff, the question becomes this: can the market step in and absorb $1 trillion in supply? Here’s Citi Matt King”

Next year looks very different. We project that the private sector will have to absorb c.$1tn of securities – the highest number since 2012. The main driver for this is our anticipated reduction in ECB purchases from €780bn this year to €150bn in 2018. The faster pace of Fed balance sheet reduction we can now expect cements our impression that next year will see a big shift away from the current status quo. Assuming that Fed balance sheet reduction begins in September, the US market will have to absorb a further $450bn of supply in addition to the gap left by the ECB.

KingFaithCBs

So yeah, less money chasing assets that are thereby less scarce should, all else equal, lead to a decline in the prices of those assets.

Relatedly, when the rolloff starts, they’re removing the crutch that kept a lid on yields for safe havens and as these assets become less scarce (and thus as the private sector is forced to step in and take down supply), it’s reasonable to expect yields to rise, thereby removing some of the incentive for investors to chase down the quality ladder. In short: once the hunt for yield and attendant bid for risk assets dries up, so does the rally. Or at least that’s the concern.

Bloomberg had an amusingly simple take on all of this out the other day. Here it is:

Has this ever been done before?

No. That’s why investors and borrowers don’t know what to expect.

Right.

But on Friday, Deutsche Bank asked another, more nuanced question. Specifically, this:

Every dollar of paper currency the Fed has ever issued was historically matched by a dollar increase in the Fed’s SOMA Treasuries holding. QE has made this equation irrelevant. With SOMA set to begin shrinking later this year, what happens when the Fed’s currency stock outgrows its Treasuries holding?

There are a couple of alternatives, but the most hilarious of which would basically entail your house serving as collateral for the paper money in your wallet.

More below…

Via Deutsche Bank

Every dollar of paper currency the Fed has ever issued was historically matched by a dollar increase in the Fed’s SOMA Treasuries holding. QE has made this equation irrelevant. With SOMA set to begin shrinking later this year, what happens when the Fed’s currency stock outgrows its Treasuries holding?

Despite the Fed’s openness this week about the timing and mechanics of its balance sheet normalization plan, it left a very important question unanswered. Will the Fed hold Agency MBS as collaterals against the Federal Reserve notes in circulation? The answer to this determines everything from Treasury net supply to the quantity of bank reserve balances and the size of the Fed’s balance sheet in the future.

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Why the Fed needs to own Treasuries

In 1913, the Federal Reserve began issuing the nation’s currency, taking over the responsibility from the Treasury Department. For the Fed’s currency, which is called Federal Reserved notes, to be as good as those issued by the US Treasury, they had to be collateralized in lawful money of the United States, according to Section 16 of the Federal Reserve Act.

Over the next 95 years, the Fed had always held an equal amount in Treasuries, US coins, gold and SDR certificates as there were Federal Reserve notes in circulation. Only after QE started in 2008, the Fed began owning a portfolio of Treasuries and MBS much larger than its Federal Reserve note obligations.

Since 2008, FR notes in circulation have nearly doubled from $800bn to $1.56 trillion. The Fed estimates that as many as two-thirds of the notes are physically held outside of the US, mostly because demand for US currency as a safe store of value continues to grow. At a 6% y/y growth rate, FR notes in circulation would expand to $1.8 trillion by mid 2020. This is where things get interesting.

DBFigure2

What would the Fed rather: all-Treasuries or small excess reserves? Given the Fed’s estimate of caps for Treasuries runoff announced this week, the Fed’s Treasuries holding is expected to drop to $1.8 trillion also by mid 2020. At this point, the Fed will have a decision to make. It can either continue to shrink its Treasuries portfolio – and hence explicitly starts using agency MBS as collateral for its FR note obligations – or it restarts buying Treasuries, as it has done in all the years before QE when its currency stock grew larger than its Treasuries portfolio.

The Federal Reserve Act allows the collateral security to be any obligations that are fully guaranteed a US agency (which Fannie Mae and Freddie Mac still are). However, there is little evidence to suggest that the Fed plans to keep MBS on its balance sheet for the long haul. Fed officials speaking on the balance sheet policy all tend to mention wanting to return to an all-Treasuries portfolio at some point.

The issue, however, is that doing so would sufficiently keep the Fed balance sheet large. Moreover, staying with an all-Treasuries portfolio directly runs counter to the Fed’s goal of reducing the supply of reserve balances. We illustrate why below.

Scenario A: Only Treasuries as collateral, large supply of reserves left behind

If the Fed targets an all-Treasuries portfolio, it will likely start buying Treasuries in 2020 when its stock of FR notes and Treasuries holding crossover. Even though its MBS holding will continue to fall, the Fed will be adding Treasuries at the same or faster rate to match the currency growth.

Reserve balances by 2020 will fall to around $1.2 trillion from $2.1 trillion today. If the Fed restarts buying Treasuries, reserve balances will be drained only at the same rate as MBS runoff, which we project will fall to $8-$12bn per month, depending on where interest rates might be at that time.

At this rate, it would be 2030 at the earliest before the Fed can reduce the supply of reserve balances to the pre-crisis level. Its balance sheet likely would not fall below $3 trillion before expanding again. On the flip side, Treasury net supply after 2020 would be smaller than otherwise since the Fed will be reinvesting again. All the Fed rhetoric considered, we think this is the path the Fed most likely will take.

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Scenario B: Treasuries and MBS as collateral, Fed drains excess reserves and gets a smaller balance sheet

If the Fed wants to focus on draining reserve balances, it can do so by letting Treasuries rundown below the currency stock. The Fed will collateralize its FR notes with both Treasuries and MBS, but forgo its all-Treasuries objective.

Since the Fed is allowing both Treasuries and MBS to runoff, reserve balances will fall at a much faster rate. Total reserve balances will fall below $200bn by early 2022, and at that level excess reserves most likely would have been fully extinguished. At this point, the Fed’s combined Treasuries and MBS portfolio will be roughly the same size as FR notes outstanding, and it would start buying Treasuries to achieve the desired asset mix.

The Fed’s balance sheet would also drop to around $2.4 trillion in 2022 before expanding again to commiserate with currency growth. This scenario implies that Treasury net issuance will stay high from 2020 to 2022 as the Fed allows more holdings to mature. Although the Fed could extinguish reserves earlier and have a smaller balance sheet with this approach, we think the Fed would avoid doing so out of concerns for withdrawing too much liquidity and holding onto MBS for too long.

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One thought on “The Money In Your Wallet Is About To Be Collateralized By Your House

  1. “The Fed’s balance sheet would also drop to around $2.4 trillion in 2022 before expanding again to commiserate with currency growth”…. so the balance sheet will hold hands with currency growth or maybe just send a get-well card?

    Like

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